CENTRAL BANKS AND THE MARKETS: ENABLING THE ADDICTION
TIME for equity investors to send Janet Yellen some champagne, or at least a bunch of flowers. Once again, markets are rising because of something that a central banker said. In a speech yesterday, Ms Yellen highlighted the complex relationship between central banks and markets. Recall that the Fed raised rates in December. Ms Yellen first notes that
The proviso that policy will evolve as needed is especially pertinent today in light of global economic and financial developments since December, which at times have included significant changes in oil prices, interest rates, and stock values.
Those market declines don’t mean that the Fed has altered its outlook for economic growth and inflation. But they were still important because, she adds
investors responded to those developments by marking down their expectations for the future path of the federal funds rate, thereby putting downward pressure on longer-term interest rates and cushioning the adverse effects on economic activity
In other words, the markets anticipated that, because they themselves were falling, the Fed would not tighten as quickly as before. So the Fed didn’t actually need to act to stabilise the economy; market anticipation of Fed action did the trick. As in Keynes’s famous beauty contest analogy, we have reached the higher levels of reasoning. Of course, this process still needed the Fed to play along with market reasoning and it is. On the pace of rate rises, Ms Yellen said
Reflecting global economic and financial developments since December, however, the pace of rate increases is now expected to be somewhat slower. For example, the median of FOMC participants’ projections for the federal funds rate is now only 0.9 percent for the end of 2016 and 1.9 percent for the end of 2017, both 1/2 percentage point below the December medians.
This relationship between the Fed’s actions and market returns dates back well before Ms Yellen’s tenure. GMO, a fund management company, recently published a paper looking at market movements on the day of Fed meetings. The Fed only meets eight times a year. But since 1984, the returns on the days of Fed meetings have provided a quarter of all returns. Take those returns away and US equities would look reasonably priced under Robert Shiller’scyclically-adjusted price-earnings ratio methodology. Indeed, in the depths of the crisis, the market would probably have fallen back to a single-digit p/e. The Fed prevented the market from reverting to the mean.
Here is the difficulty. Studies suggest central bank support for asset prices, via quantitative easing, has increased inequality in both America and Britain. But the central banks would argue that this was a price worth paying in staving off the much greater threat of an economic collapse.
But this policy of intervening when markets wobble, dating all the way back to the 1980s, has a steadily higher price. Over time, rates get lower and lower and valuations tend higher. Debtors get used to ultra-low interest rates and keep borrowing (that’s the point of the policy, after all). But this means that the potential cost of a reversion to “normal” levels of interest rates gets even greater; imagine what would happen to homeowners if mortgage rates were 6-7%. What would happen to confidence if the Shiller p/e fell from its current 25.6 to the historic average of 16.7?
Central banks don’t want that to happen and investors know that central banks don’t want it to happen. So the two are locked together like a barman and his most profitable customer, endlessly pouring one more drink to fend off the hangover and trying to forget about the cirrhosis that might set in. This is not a new problem, of course; your blogger was worrying about it six years ago. But we don’t seem to be any nearer solving it.